Reserve Bank should be clear on its future course of action

The flat to inverted shape of the yield curves can change quickly if the Reserve Bank of India (RBI) signals a softening of its stance on inflation. The market at this juncture does not expect a softening of the RBI’s stance on inflation and is content shorting the short end of the curve. Given the nature of the curve, the RBI’s future moves will be watched closely by the market. An unwinding of spread inversion trades will cause yields curves to move violently. The communication by the RBI on its future course of action should be clear and precise if there is to be an orderly movement in yields curves.The bond market received a rude shock when the RBI raised the benchmark repo rate by a higher-than-expected 50 basis points (bps). The rate hike took the repo rate to 8% from 7.5% pushing up government bond yields. The 10 year benchmark government bond saw yields move up by 15 bps post the hike with the 7.80% 2021 government bond yield going up to 8.45% levels from pre policy levels of 8.30%. Overnight money market rates moved up by 50 bps following the hike and call money rates traded at 8% levels from 7.5% levels. Money market securities yields moved up with 91 day and 364 day Treasury bill yields moving up by 30 bps and 25 bps, respectively.Three-month and one-year bank CD (certificate of deposit) yields rose 40 bps and 20 bps, respectively.Five and ten year AAA corporate bond yields rose by 8 bps and 12 bps, respectively. OIS (overnight index swaps) curve steepened by 40 bps with one-year yields moving up by 34 bps and five-year OIS yields moving down 6 bps.The government bond yield curve is flat to inverted with one, five and ten year government bond yields, all trading at 8.45% to 8.50% levels. The corporate bond yield curve is inverted with one and two year corporate bond yields trading higher than five and ten year corporate bond yields.

The interest rate swap curve is inverted with one year OIS yield trading far higher than the five year OIS yield.The five year OIS yield came off by 6 bps week on week, despite showing a negative reaction immediately after the rate hike. Five year OIS went up from pre policy levels of 8.60% to 8.75% post the rate hike and then fell sharply to close the week at 7.53% levels.The fact that yields at the short end of the curve is trading at higher levels than yields at the long end of the curve suggests that the RBI will either raise policy rates or maintain them at higher levels for the next few months. The RBI has indicated that inflation is likely to stay at elevated levels till December 2011 before trending down and that would mean policy rates will be at current levels of even higher leading up to December 2010.Liquidity as measured by the bids for repo in the LAF (liquidity adjustment facility) auction of the RBI is in a deficit mode with banks borrowing at repo rate of 8% on a daily basis. As long as banks continue to borrow in the LAF auction, short-end rates will trade at levels higher than 8%. The RBI is comfortable with this situation, as it believes that policy rates are being transmitted into the system.Government bond auctionThe government auctioned  Rs12,000 crore of bonds last week. The bonds auctioned were 7.83% 2018 bond for Rs3,000 crore, 7.80% 2021 bond for Rs6,000 crore and 8.30% 2040 bond for Rs3,000 crore.

The cut offs came in at 8.50%, 8.47%, and 8.73%, respectively. The government is scheduled to auction Rs12,000 crore of bonds this week.The writer is editor ofwww.investorsareidiots.coma website for investors.